What are the different types of sensitivity analysis techniques used in capital budgeting?

There are several types of sensitivity analysis techniques used in capital budgeting. These techniques help assess the impact of changes in key variables on the financial viability of a capital investment project. The different types of sensitivity analysis techniques include:

1. Scenario analysis: This technique involves analyzing the project's financial performance under different scenarios or assumptions. It helps identify the best and worst-case scenarios and their potential impact on the project's profitability.

2. Sensitivity analysis: Sensitivity analysis involves varying one variable at a time while keeping other variables constant to determine the effect on the project's financial metrics, such as net present value (NPV) or internal rate of return (IRR). It helps identify the most sensitive variables and their impact on the project's profitability.

3. Break-even analysis: Break-even analysis determines the level of sales or production at which the project's revenues equal its costs, resulting in zero profit. It helps identify the minimum level of sales required for the project to be financially viable.

4. Monte Carlo simulation: This technique involves running multiple simulations using random values within specified ranges for each variable to assess the project's financial performance. It provides a range of possible outcomes and their probabilities, helping decision-makers understand the project's risk profile.

5. Sensitivity tornado diagram: A sensitivity tornado diagram visually represents the impact of different variables on the project's financial metrics. It helps identify the variables with the most significant impact and their direction (positive or negative) on the project's profitability.

6. Decision tree analysis: Decision tree analysis involves mapping out different decision paths and their associated probabilities and outcomes. It helps evaluate the financial viability of different investment options and identify the optimal decision path.

By utilizing these sensitivity analysis techniques, decision-makers can gain a better understanding of the potential risks and uncertainties associated with capital investment projects, enabling them to make more informed decisions.